The Conservatives must stick to free-market principles

Given the dire state of the public finances, the Conservatives have rightly resisted the temptation to seek short-term political gain by engaging in a bidding war with the government based on increased borrowing and unfunded tax cuts.

The Conservatives may have suffered a temporary dip in popularity as a result of their principled stance. Yet in the years to come they will benefit from a gap developing between their policies and those of the government.

As the effects of recession expand from the financial sector to the wider economy and unemployment balloons, it will become very apparent that  as in Japan during the 1990s  extra state spending will not bring about economic recovery.

Indeed, higher government borrowing threatens to crowd out the private sector investment needed to bring about economic growth. Confidence in the UKs fiscal stability could be shattered.

If foreign investors and multinationals know that British taxes will, sooner or later, have to rise dramatically to pay for a Keynesian spending spree, they are likely to take their money elsewhere.

There is also a danger that, as with Roosevelts New Deal, the state will gain a larger structural role in the economy, with negative implications for its long-term dynamism. The Conservatives should therefore be steadfast in opposing further bailouts and nationalisations, making it clear that the banks were a special case.

Shadow chancellor George Osborne has correctly pointed out that regulatory failure was partly responsible for the financial crisis. For example, the Financial Services Authority failed to address adequately the problems developing at Northern Rock, and hampered the Bank of England in its traditional role as lender of last resort.

Monetary policy was also to blame. Interest rates were kept too low for too long, especially by the US Federal Reserve in the wake of 9/11. A focus on a narrow measure of inflation meant that big rises in the money supply were largely ignored, and an asset price bubble developed.

In the context of the current debate over economic fundamentals, it is essential that the Conservatives emphasise how misguided government interventions contributed to current problems. But there is also room for a much more positive agenda.

The growth of unemployment can be reduced and the prospects of recovery strengthened by a programme of supply-side measures. Welfare reform should be an urgent priority, otherwise many of the short-term unemployed will become dependent on benefits for the long-term. The Conservatives should also reconsider their support for the minimum wage or at least push for its level to be reduced.

Perhaps most importantly, the burden of regulation on businesses must be tackled. This may mean abandoning policies cherished by some members of the shadow cabinet, in areas such as the environment and employment law.

We are now entering a particularly dangerous period for the market economy, with its opponents blaming the mistakes of central banks and financial regulators on the market. It is therefore absolutely essential that the Conservative Party resists strongly the enemies of economic freedom and makes the case that free-market policies are the best way of dealing with recession.

Dr Richard Wellings is Deputy Editorial Director of the Institute of Economic Affairs.